Dear High Inflation, Rest in Hell.

Prof. Srinivasan’s monetarist history lesson tells us that to control inflation either tax rate should be hiked or monetary tightening, or both. He is asking Indian authorities to do what British did in early eighties. Though his prescriptions seem weird, yet this is exactly the Government of India (GoI) should do now. Although the chance is very less that the government of the day would pursue such vote-killing policies, yet this will benefit the country for sure. Why such tough prescription? Though we both have the same prescription, yet my reason is bit different from Srinivasan’s.

First, i discuss why this prescription looks weird and then tell why this serves better the economy.

1.      We need to ask what kind of inflation Britain reduced: demand (originated) inflation or supply (originated) inflation? To counter supply-shock in the 1970s Britain used monetary and fiscal policy to stimulate economy. Hence, disinflationary policies worked.

2.      Srinivasan seems to attribute this inflation to excess demand. A measure of excess demand is “core inflation”. It is the non-fuel non-food inflation and is almost in control.  Food inflation is the biggest contributing factor to high inflation.

3.      How can we control supply inflation with a monetary tightening? We know monetary policy can cool down only core inflation. Optimal monetary policy should stabilize the inflation in sticky prices, so central banks should not try to counteract commodity price inflation or deflation.

4.      If he is prescribing for either a tax hike or severe monetary tightening, then the economy may go to hell again. We know that both the Euro area and the US are not out of woods yet. In fact, in a recent IMF speech by former US Treasury Secretary Larry Summers, endorsed by Krugman, predict that the US economy may be slipping into a “secular stagnation”. If that is the case, then our exports demand would remain weak for long time. In this case, it is not right to step up the monetary brake now.

5.      What is holding back India growth story: high inflation or governance pause on reforms, or depressed advance economies? To be fair, each accounts for one-third of the slowdown.

6.      Prof. Srinivasan says deficits crowds out productivity-enhancing private investment. Of course, it is true. But we need to ask by how much. It is the reforms and scams that has choked investment sector. Availability of credit is indeed a factor. But this is not a big factor compared to government inaction. We should not also forget that in this period government inaction forced India Inc to go abroad. Indian industrialists Ratan Tata, Kumar Mangalam Birla, Anand Mahindra spoke to media venting out their anger on government. Deepak Parekh puts it nicely “Earlier, investing abroad seemed to be a risk diversification but the current impasse (in governance) makes it a necessity for companies to look elsewhere,"

To put it in one sentence, RBI’s fighting has not been successful and that is because the government is not cooperating. The question that automatically follows is how logical is this to argue that RBI should step up its effort to rein in inflation.

In the present circumstances it is a fair assumption that growth is going to remain sluggish throughout the next year. What shape the economy will have next year depends upon the General election to be held next year. If a clear mandate comes, it may help the policy making faster and investors would gain confidence and investment would rebound. But if we get a fractured mandate economic uncertainty will rise, thereby negatively affecting key macroeconomic variables. And given coalition politics and exit polls, it seems that we may be heading for a not-clear mandate.

The recent loss of Congress party in all the four assembly elections heightens this uncertainty. One impact of this loss is that the reforms in the Parliament would be stalled till the next Central government is formed. Investors fear that bills passed by this government may be overturned by the next government. So, a rational businessman would prefer to wait and watch.

Both inflation and inflationary expectation have been sticky due to both RBI’s “Boiling Frog Syndrome” approach and GoI’s spending binge. We also know that success of monetary policy is contingent upon fiscal policy. So, both should go hand in hand to achieve inflation reduction objective. While the GoI is shedding crocodile tears for high inflation, RBI has been fighting a lone battle since March 2010, without much success. As of now GoI has spent 84% of expenditure sanctioned in the Parliament and that too without accounting for fuel subsidies! It suggests that GoI is less serious in containing inflation.

Further, it is an election year. And the recent loss may prompt the central government to go for more vote-wooing sops and freebies which implies more expenditure. So, the government might be tempted to spend more. Given that we can’t have a US-style drama of “government shutdown” fiscal deficit is bound to exceed its target in this fiscal. Neither a huge cut in the expenditure is possible, as Finance Minister Chidambaram assures us nor a up in the tax rate is possible. These factors translate into higher inflationary expectations, and thus, higher inflation. This will surely jeopardise RBI’s efforts to bring down inflation to moderate levels.

So from the above discussion we find that four things warrant for such a tough action. They are: (1) domestic slowdown will persist for at least one year, (2) central government has spent 84% of its expenditure sanctioned for this fiscal, (3) this year being an election year, central government might be tempted to spend more, and finally the advanced economies will be weak for at least one year.

But the question is how to kill inflation and its cousin inflation expectation. So far RBI is not successful in its war against inflation. Former RBI governor Subbarao admitted that it was this “baby-step approach” of the RBI that failed to control inflation. So, RBI should tell the government clearly and loudly that it is serious to bring down inflation and it would keep the interest rate heightened until central government pursues prudent fiscal policy. More importantly, if it wants to get victory against inflation it needs to abandon its “piece-meal approach” of hiking repo rate by 25 basis points each time. That means RBI can go for an all-out attack on inflation; it needs to hike interest rate sharply. Rajan has been less tough on inflation than he speaks. And if he continues to follow his predecessor’s legacy, it would land the Indian economy no where: neither inflation will cool down nor growth will peak up.

However, the reality, as emphasized by Srinivasan is that monetary policy is going to be of little help unless and until fiscal policy shows discipline. But fiscal indiscipline is the order of the day. This is why i am less confident that rise in interest rate will reduce retail inflation. Yet it is worth trying, given that growth is going to remain sluggish. Hence, pursuing such anti-inflationary policies would ensure minimal output loss (that is, a small sacrifice ratio). Hence, this is the best time to reduce inflation.